An increase in the stock market's overall performance, like the one that took place in October, can turn inexperienced investors into trade-happy amateurs, according to Brigham Young University business professors in a study published in The Review of Financial Studies
"When investors start off in the market, they tend to trade pretty conservatively," said Steven Thorley
Thorley and co-researchers Keith Vorkink
With October's rise in the overall stock market, Thorley expects to see "an increasing interest in individuals trading in the market and measurable increases in trading volume as a result of investor overconfidence."
For their study, the trio examined trading volume – the amount of stock bought or sold monthly – on the New York Stock Exchange
"There's an old saying on Wall Street: 'Don't confuse brains with a bull market,'" said Thorley. "Investors should not assume they are more talented than average just because the market's going up, but our empirical study suggests that's just what they do."
Terrance Odean
Vorkink notes one illuminating finding from the study: a really good monthly return in the market increases trading volume by the equivalent of an extra month of trading, spread out over the six following months.
"The market makers – the exchanges, dealers and brokers – celebrate bull markets, and not just because they probably have money in the market themselves. It means that business will pick up," said Thorley, explaining that a lot of those increases in trading commissions come at the expense of overconfident investors.
This type of investor ascribes positive outcomes to themselves and negative ones to forces outside their control, said Vorkink, an associate professor of business management.
"It's a case of biased self-attribution: bad luck, or 'something outside my control is to blame,' if the market goes down, good trading skills, or 'it was me,' if the market goes up," says Vorkink, explaining that the true measure of investors' skill is how much better their stocks do than the overall market.
Using a database from the Center for Research in Security Prices
"The average investor should understand that the stock market is one of the most competitive professional arenas in the world," said Thorley, explaining that there are huge amounts of resources, expertise and time thrown at the problem of how to analyze and pick stocks that will outperform the market. "From a purely rational or strategic viewpoint, individuals shouldn't try to play this game, because the odds aren't in their favor."
Instead, investors should put their money in a well-diversified mutual fund, preferably an index fund or exchange traded fund that mirrors the market's natural rise and not trade so much, said Thorley.
"Because of the extra costs of active trading, including bid-ask spread, tax inefficiencies, and research time and cost, investors must be in the top third of all active traders in order to beat the market."